FIN 571

Net Income versus the cash flow to investors

Managers and investors are primarily interested in a firm's ability to generate cash flows to meet the firm's obligations to its debt holders and that can be distributed to stockholders; the cash flow to investors. These cash obligations and distributions include interest payments and the repayment of principal to the firm's debt holders, as well as distributions of cash to its stockholders in the form of dividends or stock repurchases. Cash flow to investors is the cash flow that a firm generates for its investors in a given period (cash receipts less cash payments and investments), excluding cash inflows from investors themselves, such as from the sale of new equity or long-term interest-bearing debt. So how is cash flow to investors different from net income? One significant difference arises because accountants do not necessarily count the cash coming into the firm and the cash going out when they prepare financial statements. Under GAAP, accountants recognize revenue at the time a sale is substantially completed, not when the customer actually pays the firm. In addition, because of the matching principle, accountants match revenues with the costs of producing those revenues regardless of whether these are cash costs to the firm during that period.8 Finally, cash flows for capital expenditures occur at the time that an asset is purchased, not when it is expensed through depreciation and amortization. As a result of these accounting rules, there can be a noticeable difference between the time when revenues and expenses are recorded and when cash is actually collected (in the case of revenue) or paid (in the case of expenses). Cash flow to investors is one of the most important concepts in finance as it identifies the cash flow in a given period that is available to meet the firm's obligations to its debt holders and that can be distributed to its stockholders. This, in turn, defines the value of their investments in the firm. The cash flow to investors is calculated as the cash flow to investors from operating activity, minus the cash flow invested in net working capital, minus the cash flow invested in long-term assets.

Informational Efficency

Markets exhibit informational efficiency if market prices reflect all relevant information about securities at a particular point in time. As suggested above, informational efficiency is influenced by operational efficiency, but it also depends on the availability of information and the ability of investors to buy and sell securities based on that information. In an informationally efficient market, market prices adjust quickly to new information as it becomes available. Prices adjust quickly because many security analysts and investors are gathering and trading on information about securities in a quest to make a profit. Note that competition among investors is an important driver of informational efficiency

Efficient Market

Markets such as those just described are called "efficient" markets. More formally, in an efficient market, security prices fully reflect the knowledge and expectations of all investors at a particular point in time. If markets are efficient, investors and financial managers have no reason to believe the securities are not priced at or near their true value. The more efficient a market is, the more likely securities are to be priced at or near their true value.

Money Center Banks

Money center banks are large commercial banks that provide both traditional and investment banking services throughout the world.

Money Market

Money markets are global markets where short-term debt instruments, which have maturities of less than one year, are traded. Money markets are wholesale markets in which the minimum transaction is $1 million and transactions of $10 million or $100 million are not uncommon. Money market instruments are lower in risk than other securities because of their high liquidity and low default risk. In fact, the term money market is used because these instruments are close substitutes for cash. The most important and largest money markets are in New York City, London, and Tokyo. Exhibit 2.2 lists the most common money market instruments and the dollar amounts outstanding as of June 2010.Large companies use money markets to adjust their liquidity positions. Liquidity, as mentioned, is the ability to convert an asset into cash quickly without loss of value. Liquidity problems arise because companies' cash receipts and expenditures are rarely perfectly synchronized. To manage liquidity, a firm can invest idle cash in money market instruments; then, if the firm has a temporary cash shortfall, it can raise cash overnight by selling money market instruments. Recall from Chapter 1 that capital markets are markets where equity and debt instruments with maturities of greater than one year are traded. In these markets, large firms finance capital assets such as plants and equipment. The NYSE, as well as the London and Tokyo stock exchanges, are capital markets. Exhibit 2.2 also lists the major U.S. capital market instruments and the dollar amounts outstanding. Compared with money market instruments, capital market instruments are less marketable, have higher default risk, and have longer maturities.

Corporations

Most large businesses are corporations. A corporation is a legal entity authorized under a state charter. In a legal sense, it is a "person" distinct from its owners. Corporations can sue and be sued, enter into contracts, issue debt, borrow money, and own assets, such as real estate. They can also be general or limited partners in partnerships, and they can own stock in other corporations. Because a corporation is an entity that is distinct from its owners, it can have an indefinite life. Although only 15 percent of all businesses are incorporated, corporations hold nearly 90 percent of all business assets, generate nearly 90 percent of revenues, and account for about 80 percent of all business profits in the United States. The owners of a corporation are its stockholders. Starting a corporation is more costly than starting a sole proprietorship or partnership. Those starting the corporation, for example, must create articles of incorporation and by-laws that conform to the laws of the state of incorporation. These documents spell out the name of the corporation, its business purpose, its intended life span (unless explicitly stated otherwise, the life is indefinite), the amount of stock to be issued, and the number of directors and their responsibilities. A major advantage of the corporate form of business organization is that stockholders have limited liability for debts and other obligations of the corporation. The corporate veil of limited liability exists because corporations are legal persons that borrow in their own names, not in the names of any individual owners. A major disadvantage of the most common corporate form of organization, compared with sole proprietorships and partnerships, is the way they are taxed. Because the corporation is a legal person, it must pay taxes on the income it earns. If the corporation then pays a cash dividend, the stockholders pay taxes on that dividend as income. Thus, the owners of corporations are subject to double taxation—first at the corporate level and then at the personal level when they receive dividends. Corporations can be classified as public or private. Most large companies prefer to operate as public corporations because large amounts of capital can be raised in public markets at a relatively low cost. Public markets, such as the New York Stock Exchange (NYSE) and NASDAQ, are regulated by the federal Securities and Exchange Commission (SEC).2 Although firms whose securities are publicly traded are technically called public corporations, they are generally referred to simply as corporations. We will follow that convention. In contrast, privately held, or closely held, corporations are typically owned by a small number of investors, and their shares are not traded publicly. When a corporation is first formed, the common stock is often held by a few investors, typically the founder, a small number of key managers, and financial backers. Over time, as the company grows in size and needs larger amounts of capital, management may decide that the company should "go public" in order to gain access to the public markets. Not all privately held corporations go public, however.

Cyclical and Long term trends in interest rates

Now let's look at some market data to see how interest rates have actually fluctuated over the past five decades in the United States. Exhibit 2.5 plots the interest rate yield on 10-year government bonds since 1960 to represent interest rate movements. In addition, the exhibit plots the annual rate of inflation, represented by the annual percent change in the consumer price index (CPI). The CPI is a price index that measures the change in prices of a market basket of goods and services that a typical consumer purchases. Finally, the shaded areas on the chart indicate periods of recession. Recession occurs when real output from the economy is decreasing and unemployment is increasing. Each shaded area begins at the peak of the business cycle and ends at the bottom (or trough) of the recession. From our discussion of interest rates and an examination of Exhibit 2.5, we can draw two general conclusions: 1. The level of interest rates tends to rise and fall with changes in the actual rate of inflation. The positive relation between the rate of inflation and the level of interest rates is what we should expect given Equation 2.1. Thus, we feel comfortable concluding that inflationary expectations have a major impact on interest rates. Our findings also explain in part why interest rates can vary substantially between countries. For example, in 2009 the rate of inflation in the United States was 2.7 percent; during the same period, the rate of inflation in Russia was 14.1 percent. If the real rate of interest is 3.0 percent, the short-term interest rate in the United States should have been around 5.7 percent and the Russian interest rate should have been around 17.1 percent . In fact, during January 2009 the U.S. short-term interest rate was about 0.5 percent and the Russian rate was 13.0 percent. Though hardly scientific, this analysis illustrates the point that countries with higher rates of inflation or expected rates of inflation will have higher interest rates than countries with lower inflation rates. The fact that both of these interest rates are below the rates of inflation reflects the weak economic conditions in 2009. 2. The level of interest rates tends to rise during periods of economic expansion and decline during periods of economic contraction. It makes sense that interest rates should increase during years of economic expansion. The reasoning is that as the economy expands, businesses begin to borrow money to build up inventories and to invest in more production capacity in anticipation of increased sales. As unemployment begins to decrease, the economic future looks bright, and consumers begin to buy more homes, cars, and other durable items on credit. As a result, the demand for funds by both businesses and consumers increases, driving interest rates up. Also, near the end of expansion, the rate of inflation begins to accelerate, which puts upward pressure on interest rates. At some point, the Federal Reserve System (the Fed) becomes concerned over the increasing inflation in the economy and begins to tighten credit, which further raises interest rates, slowing the economy down. The higher interest rates in the economy choke off spending by both businesses and consumers. During a recession, the opposite takes place; businesses and consumers rein in their spending and their use of credit, putting downward pressure on interest rates. To stimulate demand for goods and services, the Fed will typically begin to make more credit available. The result is to lower interest rates in the economy and encourage business and consumer spending. Also notice in Exhibit 2.5 that periods of business expansion tend to be much longer than periods of contraction (recessions). Since the end of the Great Depression (1929-1933), the average period of economic expansion has lasted three to four years, and the average period of contraction, about nine months. Keep in mind that the numbers given are averages and that actual periods of economic expansion and contraction can vary widely from averages. For example, the last period of business expansion lasted about 6 years (October 2001 to December 2007), and the last recession lasted 18 months (December 2007 to June 2009).

Real rate of interest

One of the most important economic variables in the economy is the real rate of interest—an interest rate determined in the absence of inflation. Inflation is the amount by which aggregate price levels rise over time. The real rate of interest is (1) the inflation-adjusted return earned by lender-savers and (2) the inflation-adjusted cost incurred by borrower-spenders when they borrow.

Extraordinary Items

Other items reported separately in the income statement are extraordinary items, which are reserved for nonoperating gains or losses. Extraordinary items are unusual and infrequent occurrences, such as gains or losses from floods, fires, or earthquakes. For example, in 1980 the volcano Mount St. Helens erupted in Washington state, and Weyerhaeuser Company reported an extraordinary loss of $67 million to cover the damage to its standing timber, buildings, and equipment. Diaz Manufacturing has no extraordinary expense item during 2011.

Pension Funds

Pension funds invest retirement funds on behalf of businesses or government agencies that provide retirement programs for their employees. Pension funds obtain money from employee and employer contributions during the employee's working years, and they provide monthly cash payments upon retirement. Because of the predictability of these cash flows, pension fund managers invest in corporate bonds and equity securities purchased in the direct financial markets and participate in the private placement market.

Preferred Stock

Preferred stock is a cross between common stock and long-term debt. Preferred stock pays dividends at a specified fixed rate, which means that the firm cannot increase or decrease the dividend rate, regardless of whether the firm's earnings increase or decrease. However, like common stock dividends, preferred stock dividends are declared by the board of directors, and in the event of financial distress, the board can elect not to pay a preferred stock dividend. If preferred stock dividends are missed, the firm is typically required to pay dividends that have been skipped in the past before they can pay dividends to common stockholders. In the event of bankruptcy, preferred stockholders are paid before common stockholders but after bondholders and other creditors. As shown in Exhibit 3.1, Diaz Manufacturing has no preferred stock outstanding, but the company is authorized to issue up to 10 million shares of preferred stock.

Efficient Market Hypothesis

Public financial markets are efficient in part because regulators such as the SEC require issuers of publicly traded securities to disclose a great deal of information about those securities to investors. Investors are constantly evaluating the prospects for these securities and acting on the conclusions from their analyses by trading them. If the price of a security is out of line with what investors think it should be, then they will buy or sell that security, causing its price to adjust to reflect their assessment of its value. The ability of investors to easily observe transaction prices and trade volumes and to inexpensively trade securities in public markets contributes to the efficiency of this process. This buying and selling by investors is the mechanism through which prices adjust to reflect the market's consensus. The theory about how well this mechanism works is known as the efficient market hypothesis.

Public Markets 2

Public markets are organized financial markets where the general public buys and sells securities through their stockbrokers. The NYSE, for example, is a public market. The SEC regulates public securities markets in the United States. This agency is responsible for overseeing the securities industry and regulating all primary and secondary markets in which securities are traded. Many corporations want access to the public markets because they are wholesale markets where issuers can sell their securities at the lowest possible funding cost. The downside for corporations selling in the public markets is the cost of complying with the various SEC regulations.

Public Markets

Public markets, such as the New York Stock Exchange (NYSE) and NASDAQ, are regulated by the federal Securities and Exchange Commission (SEC).2 Although firms whose securities are publicly traded are technically called public corporations, they are generally referred to simply as corporations. We will follow that convention

Net Working Capital

Recall from Chapter 1 that the dollar difference between total current assets and total current liabilities is the firm's net working capital: (3.2) Net working capital is a measure of a firm's ability to meet its short-term obligations as they come due. One way that firms maintain their liquidity is by holding more current assets. For Diaz Manufacturing, total current assets are $1,039.8 million, and total current liabilities are $377.8 million. The firm's net working capital is thus: To interpret this number, if Diaz Manufacturing took its current stock of cash and liquidated its marketable securities, accounts receivables, and inventory at book value, it would have $1,039.8 million with which to pay off its short-term liabilities of $377.8 million, leaving $662.0 million of "cushion." As a short-term creditor, such as a bank, you would view the net working capital position as positive because Diaz's current assets exceed current liabilities by almost three times .

Residual Cash Flows

A firm generates cash flows by selling the goods and services it produces. A firm is successful when these cash inflows exceed the cash outflows needed to pay operating expenses, creditors, and taxes. After meeting these obligations, the firm can pay the remaining cash, called residual cash flows, to the owners as a cash dividend, or it can reinvest the cash in the business.

Bankruptcy

A firm is unprofitable when it fails to generate sufficient cash inflows to pay operating expenses, creditors, and taxes. Firms that are unprofitable over time will be forced into bankruptcy by their creditors if the owners do not shut them down first. In bankruptcy the company will be reorganized or the company's assets will be liquidated, whichever is more valuable. If the company is liquidated, creditors are paid in a priority order according to the structure of the firm's financial contracts and prevailing bankruptcy law. If anything is left after all creditor and tax claims have been satisfied, which usually does not happen, the remaining cash, or residual value, is distributed to the owners.

Revenues

A firm's revenues (sales) arise from the products and services it creates through its business operations. For manufacturing and merchandising companies, revenues come from the sale of merchandise. Service companies, such as consulting firms, generate fees for the services they perform. Other kinds of businesses earn revenues by charging interest or collecting rent. Regardless of how they earn revenues, most firms either receive cash or create an account receivable for each transaction, which increases their total assets

Partnership

A partnership consists of two or more owners who have joined together legally to manage a business. About 10 percent of all businesses in the United States are organized in this manner. To form a partnership, the owners enter into an agreement that details how much capital each partner will contribute to the partnership, what their management roles will be, how key management decisions will be made, how the profits will be divided, and how ownership will be transferred in case of specified events, such as the retirement or death of a partner. A general partnership has the same basic advantages and disadvantages as a sole proprietorship. A key disadvantage of a general partnership is that all partners have unlimited liability for the partnership's debts and actions, regardless of what proportion of the business they own or how the debt or obligations were incurred. The problem of unlimited liability can be avoided in a limited partnership, which consists of general and limited partners. Here, one or more general partners have unlimited liability and actively manage the business, while each limited partner is liable for business obligations only up to the amount of capital he or she contributed to the partnership. In other words, the limited partners have limited liability. To qualify for limited partner status, a partner cannot be actively engaged in managing the business.

Primary Market

A primary market is any market where companies sell new security issues (debt or equity). For example, suppose Hewlett-Packard (HP) needs to raise $100 million for business expansion and decides to raise the money through the sale of common stock. The company will sell the new equity issue in the primary market for corporate stock—probably with the help of an underwriter, as discussed in Section 2.2. The primary markets are not well known to the general public because they are wholesale markets and the sales take place outside of the public view. A key characteristic of a primary market is that the transaction results in new money going into the firm.

Secondary market

A secondary market is any market where owners of outstanding securities can sell them to other investors. Secondary markets are like used-car markets in that they allow investors to buy or sell previously owned securities for cash. These markets are important because they enable investors to buy and sell securities as frequently as they want. As you might expect, investors are willing to pay higher prices for securities that have active secondary markets. Secondary markets are important to corporations as well because investors are willing to pay higher prices for securities in primary markets if the securities have active secondary markets. Thus, companies whose securities have active secondary markets enjoy lower funding costs than similar firms whose securities do not have active secondary markets. In contrast to primary markets, no new money goes into the firm when a secondary market transaction takes place.

Sole Proprietorship

A sole proprietorship is a business owned by one person. About 75 percent of all businesses in the United States are sole proprietorships, typically consisting of the proprietor and a handful of employees. A sole proprietorship offers several advantages. It is the simplest type of business to start, and it is the least regulated. In addition, sole proprietors keep all the profits from the business and do not have to share decision-making authority. Finally, profits from a sole proprietorship are subjected to lower income taxes than are those from the most common type of corporation. On the downside, a sole proprietor is responsible for paying all the firm's bills and has unlimited liability for all business debts and other obligations of the firm. This means that creditors can look beyond the assets of the business to the proprietor's personal wealth for payment. Another disadvantage is that the amount of equity capital that can be invested in the business is limited to the owner's personal wealth, which may restrict the possibilities for growth. Finally, it is difficult to transfer ownership of a sole proprietorship because there is no stock or other such interest to sell. The owner must sell the company's assets, which can reduce the price that the owner receives for the business.

Liquidity

A term closely related to marketability is liquidity. Liquidity is the ability to convert an asset into cash quickly without loss of value. In common use, the terms marketability and liquidity are often used interchangeably, but they are different. Liquidity implies that when the security is sold, its value will be preserved; marketability does not carry this implication.

Semistrong Form Efficiency

A weaker form of the efficient market hypothesis, known as the semistrong-form, holds only that all public information—information that is available to all investors—is reflected in security prices. Investors who have private information are able to profit by trading on this information before it becomes public. For example, suppose that conversations with the customers of a firm indicate to an investor that the firm's sales, and thereby its cash flows, are increasing more rapidly than other investors expect. To profit from this information, the investor buys the firm's stock. By buying the stock, the investor helps drive up the price to the point where it accurately reflects the higher level of cash flows. The concept of semistrong-form efficiency is a reasonable representation of the public stock markets in developed countries such as the United States. In a market characterized by this sort of efficiency, as soon as information becomes public, it is quickly reflected in stock prices through trading activity. Studies of the speed at which new information is reflected in stock prices indicate that by the time you read a hot tip in the Wall Street Journal or a business magazine, it is too late to benefit by trading on it.

The Assumption of Arm's Length Transactions

Accounting is based on the recording of economic transactions that can be quantified in dollar amounts. It assumes that the parties to a transaction are economically rational and are free to act independently of each other. To illustrate, let's assume that you are preparing a personal balance sheet for a bank loan on which you must list all your assets. You are including your BMW 325 as an asset. You bought the car a few months ago from your father for $3,000 when the retail price of the car was $15,000. You got a good deal. However, the price you paid, which would be the number recorded on your balance sheet, was not the market price. Since you did not purchase the BMW in an arm's-length transaction, your balance sheet would not reflect the true value of the asset.

The matching Principle

Accounting tries to match revenue on the income statement with the expenses incurred to generate the revenue. In practice, this principle means that revenue is first recognized (according to the realization principle) and then is matched with the costs associated with producing the revenue. For example, if we manufacture a product and sell it on credit (accounts receivable), the revenue is recognized at the time of sale. The expenses associated with manufacturing the product—expenditures for raw materials, labor, equipment, and facilities—will be recognized at the same time. Notice that the actual cash outflows for expenses may not occur at the same time the expenses are recognized. It should be clear that the figures on the income statement more than likely will not correspond to the actual cash inflows and outflows during the period.

Market Value Versus Book Value

Although accounting statements are helpful to analysts and managers, they have a number of limitations. One of these limitations, mentioned earlier, is that accounting statements are historical—they are based on data such as the cost of a building that was built years ago. Thus, the value of assets on the balance sheet is what the firm paid for them and not their current market value—the amount they are worth today. Investors and management, however, care about how the company will do in the future. The best information concerning how much a company's assets can earn in the future, as well as how much of a burden its liabilities are, comes from the current market value of those assets and liabilities. Accounting statements would therefore be more valuable if they measured current value. The process of recording assets at their current market value is often called marking to market. In theory, everyone agrees that it is better to base financial statements on current information. Marking to market provides decision makers with financial statements that more closely reflect a company's true financial condition; thus, they have a better chance of making the correct economic decision, given the information available. For example, providing current market values means that managers can no longer conceal a failing business or hide unrealized gains on assets. On the downside, it can be difficult to identify the market value of an asset, particularly if there are few transactions involving comparable assets. Critics also point out that estimating market value can require complex financial modeling, and the resulting numbers can be open to manipulation and abuse. Finally, mark-to-market accounting can become inaccurate if market prices deviate from the "fundamental" values of assets and liabilities. This might occur because buyers and sellers have either incorrect information, or have either over-optimistic or over-pessimistic expectations about the future. `

Amortization Expense

Amortization is the process of writing off expenses for intangible assets—such as patents, licenses, copyrights, and trademarks—over their useful life. Since depreciation and amortization are very similar, they are often lumped together on the income statement. Both are noncash expenses, which means that an expense is recorded on the income statement, but the associated cash does not necessarily leave the firm in that period. For Diaz Manufacturing, the depreciation and amortization expense for 2011 was $83.1 million. At one time, goodwill was one of the intangible assets subject to amortization. As of June 2001, however, goodwill could no longer be amortized. The value of the goodwill on a firm's balance sheet is now subject to an annual impairment test. This test requires that the company annually value the businesses that were acquired in the past to see if the value of the goodwill associated with those businesses has declined below the value at which it is being carried on the balance sheet. If the value of the goodwill has declined (been impaired), management must expense the amount of the impairment. This expense reduces the firm's reported net income.

Marketability

An important characteristic of a security to investors is its marketability. Marketability is the ease with which a security can be sold and converted into cash. A security's marketability depends in part on the costs of trading and searching for information, so-called transaction costs. The lower the transaction costs, the greater a security's marketability. Because secondary markets make it easier to trade securities, their presence increases a security's marketability.

Depreciation Expense

An interesting feature of financial reporting is that companies are allowed to prepare two sets of financial statements: one for tax purposes and one for managing the company and for financial reporting to the SEC and investors. For tax purposes, most firms elect to accelerate depreciation as quickly as is permitted under the tax code. The reason is that accelerated depreciation results in a higher depreciation expense to the income statement, which in turn results in a lower earnings before taxes (EBT) and a lower tax liability in the first few years after the asset is acquired. The good news about accelerating depreciation for tax purposes is that the firm pays lower taxes but the depreciation expense does not represent a cash flow. The depreciation method does not affect the cost of the asset. In contrast, straight-line depreciation results in lower depreciation expenses to the income statement, which results in higher EBT and higher tax payments. Firms generally use straight-line depreciation in the financial statements they report to the SEC and investors because it makes their earnings look better. The higher a firm's EBT, the higher its net income. It is important to understand that the company does not take more total depreciation under accelerated depreciation methods than under the straight-line method; the total amount of depreciation expensed to the income statement over the life of an asset is the same. Total depreciation cannot exceed the price paid for the asset. Accelerating depreciation only alters the timing of when the depreciation is expensed.

Agency Costs

As we discussed earlier in this chapter, many relationships in business are agency relationships. Agents can be bound both legally and ethically to act in the interest of the principal. Financial managers have agency obligations to act honestly and to see that subordinates act honestly with respect to financial transactions. Financial managers, when they are guilty of misconduct, present a serious danger to stockholder wealth. A product recall or environmental offense may cause temporary declines in stock prices. However, revelations of dishonesty, deception, and fraud in financial matters can have a huge impact on the stock price. If the dishonesty is flagrant, the firm may go bankrupt, as we saw with the bankruptcies of Enron and WorldCom.

Chief Financial Officer CFO

As we discussed earlier, financial managers are concerned with a firm's investment, financing, and working capital management decisions. The senior financial manager holds one of the top executive positions in the firm. In a large corporation, the senior financial manager usually has the rank of vice president or senior vice president and goes by the title of chief financial officer, or CFO. In smaller firms, the job tends to focus more on the accounting function, and the top financial officer may be called the controller or chief accountant. In this section we focus on the financial function in a large corporation.

Financial Intermediation

As we mentioned earlier, many business firms are too small to sell their debt or equity directly to investors. They have neither the expert knowledge nor the financing requirements to make transacting in wholesale markets cost effective. When these companies need funds for capital investments or for liquidity adjustments, their only feasible choice is to borrow in the indirect market from a financial institution. These financial institutions act as intermediaries, converting financial securities with one set of characteristics into securities with another set of characteristics. This process is called financial intermediation. The hallmark of indirect financing is that a financial institution—an intermediary—stands between the lender-saver and the borrower-spender. This route is shown at the bottom of Exhibit 2.1.

Three Fundamental Decisions in Financial Management

Based on our discussion so far, we can see that financial managers are concerned with three fundamental decisions when running a business: 1. Capital budgeting decisions: Identifying the productive assets the firm should buy. 2. Financing decisions: Determining how the firm should finance or pay for assets. 3. Working capital management decisions: Determining how day-to-day financial matters should be managed so that the firm can pay its bills, and how surplus cash should be invested. Exhibit 1.2 shows the impact of each decision on the firm's balance sheet. We briefly introduce each decision here and discuss them in greater detail in later chapters

Conflicts of Interest

Conflicts of interest often arise in agency relationships. A conflict of interest in such a situation can arise when the agent's interests are different from those of the principal. For example, suppose you're interested in buying a house and a local real estate agent is helping you find the home of your dreams. As it turns out, the dream house is one for which your agent is also the listing agent. Your agent has a conflict of interest because her professional obligation to help you find the right house at a fair price conflicts with her professional obligation to get the highest price possible for the client whose house she has listed. Organizations can be either principals or agents and, hence, can be parties to conflicts of interest. In the past, for example, many large accounting firms provided both consulting services and audits for corporations. This dual function may compromise the independence and objectivity of the audit opinion, even though the work is done by different parts of the firm. For example, if consulting fees from an audit client become a large source of income, is the auditing firm less likely to render an adverse audit opinion and thereby risk losing the consulting business? Conflicts of interest are typically resolved in one of two ways. Sometimes complete disclosure is sufficient. Thus, in real estate transactions, it is not unusual for the same lawyer or realtor to represent both the buyer and the seller. This practice is not considered unethical as long as both sides are aware of the fact and give their consent. Alternatively, the conflicted party can withdraw from serving the interests of one of the parties. Sometimes the law mandates this solution. For example, recent legislation requires that public accounting firms stop providing certain consulting services to their audit clients.

Current Assets and Liabilities

Current assets are assets that can reasonably be expected to be converted into cash within one year. Besides cash, which includes investments in marketable securities such as money market instruments, other current assets are accounts receivable, which are typically due within 30 to 45 days, and inventory, which is money invested in raw materials, work-in-process inventory, and finished goods. Diaz's current assets total $1,039.8 million. Current liabilities are obligations payable within one year. Typical current liabilities are accounts payable, which arise in the purchases of goods and services from vendors and are normally paid within 30 to 60 days; notes payable, which are formal borrowing agreements with a bank or some other lender that have a stated maturity; and accrued taxes from federal, state, and local governments, which are taxes Diaz owes but has not yet paid. Diaz's total current liabilities equal $377.8 million.

Dealers

Dealers, in contrast, "make markets" for securities and do bear risk. They make a market for a security by buying and selling from an inventory of securities they own. Dealers make their profit, just as retail merchants do, by selling securities at prices above what they paid for them. The risk that dealers bear is price risk, which is the risk that they will sell a security for less than they paid for it.

Distribution

Distribution is the process of marketing and reselling the securities to investors. Because security prices can take large, unexpected swings, a quick resale of all the securities is important. To that end, the underwriters often form sales syndicates, consisting of a number of different investment banking firms, to sell the securities. If the securities are not sold within a few days, the syndicate is disbanded, and the individual syndicate members sell the unsold securities at whatever price they can get.

Positions Reporting to CFO

Exhibit 1.3 also shows the positions that typically report to the CFO in a large corporation and the activities managed in each area. • The treasurer looks after the collection and disbursement of cash, investing excess cash so that it earns interest, raising new capital, handling foreign exchange transactions, and overseeing the firm's pension fund managers. The treasurer also assists the CFO in handling important Wall Street relationships, such as those with investment bankers and credit rating agencies. • The risk manager monitors and manages the firm's risk exposure in financial and commodity markets and the firm's relationships with insurance providers. • The controller is really the firm's chief accounting officer. The controller's staff prepares the financial statements, maintains the firm's financial and cost accounting systems, prepares the taxes, and works closely with the firm's external auditors. • The internal auditor is responsible for identifying and assessing major risks facing the firm and performing audits in areas where the firm might incur substantial losses. The internal auditor reports to the board of directors as well as the CFO.

Expenses

Expenses are the various costs that the firm incurs to generate revenues. Broadly speaking, expenses are (1) the value of long-term assets consumed through business operations, such as depreciation expense; and (2) the costs incurred in conducting business, such as labor, utilities, materials, and taxes.

Exchanges and over the counter Markets

Financial markets can be classified as either "organized" markets (more commonly called exchanges) or over-the-counter markets. Traditional exchanges, such as the New York Stock Exchange (NYSE), provide a physical meeting place and communication facilities for members to buy and sell securities or other assets (such as commodities like oil or wheat) under a specific set of rules and regulations. Members are individuals who represent securities firms as well as people who trade for their own accounts. Only members can use the exchange. Securities not listed on an exchange are bought and sold in the over-the-counter (OTC) market. The OTC market differs from organized exchanges in that the "market" has no central trading location. Instead, investors can execute OTC transactions by visiting or telephoning an OTC dealer or by using a computer-based electronic trading system linked to the OTC dealer. Traditionally, stocks traded over the counter have been those of small and relatively unknown firms, most of which would not qualify to be listed on a major exchange. However, electronic trading has become much more important in recent years. Many large well-known firms, such as Google and Microsoft, now trade on electronic exchanges such as NASDAQ. In fact, even in organized markets like the NYSE, a large fraction of trades are now completed electronically

True (Intrinsic) Value

Financial markets, such as the bond and stock markets, help bring buyers and sellers of securities together. They reduce the cost of buying and selling securities by providing a physical location or computer trading system where investors can trade securities. The supply and demand for securities are better reflected in organized markets because much of the total supply and demand for securities flows through these centralized locations or trading systems. Any price that balances the overall supply and demand for a security is a market equilibrium price. Ideally, economists would like financial markets to price securities at their true (intrinsic) value. A security's true value is the present value (the value in today's dollars) of the cash flows an investor who owns that security can expect to receive in the future. This present value, in turn, reflects all available information about the size, timing, and riskiness of the cash flows at the time the price was set.3 As new information becomes available, investors adjust their cash flow estimates and, through buying and selling, the price of a security adjusts to reflect this information.

Financing Decisions

Financing decisions are concerned with the ways in which firms obtain and manage long-term financing to acquire and support their productive assets

Assets

For current assets, market value and book value may be reasonably close. The reason is that current assets have a short life cycle and typically are converted into cash quickly. Then, as new current assets are added to the balance sheet, they are entered at their current market price. In contrast, long-term assets, which are also referred to as fixed assets, have a long life cycle and their market value and book value are not likely to be equal. In addition, if an asset is depreciable, the amount of depreciation shown on the balance sheet does not necessarily reflect actual loss of economic value. As a general rule, the longer the time that has passed since an asset was acquired, the more likely it is that the current market value will differ from the book value. For example, suppose a firm purchased land for a trucking depot in Atlanta, Georgia, 30 years ago for $100,000. Today the land is nestled in an expensive suburban area and is worth around $5.5 million. The difference between the book value of $100,000 and the market value is $5.4 million. In another example, say an airline company decided to replace its aging fleet of aircraft with new fuel-efficient jets in the late 1990s. Following the September 11, 2001, terrorist attack, airline travel declined dramatically; and during 2003 nearly one-third of all commercial jets were "mothballed." In 2003 the current market value of the replacement commercial jets was about two-thirds their original cost. Why the decline? Because the expected cash flows from owning a commercial aircraft had declined a great deal.

Time value of money

For example, the longer you go without paying your credit card balance, the more interest you must pay the bank for the use of the money. The interest accrues because of the time value of money; the longer you have access to money, the more you have to pay for it. The time value of money is one of the most important concepts in finance and is the focus of Chapters 5 and 6.

The Cost Principle

Generally, the value of an asset that is recorded on a company's "books" reflects its historical cost. The historical cost is assumed to represent the fair market value of the item at the time it was acquired and is recorded as the book value. Over time, it is unlikely that an asset's book value will be equal to its market value because market values tend to change over time. The major exception to this principle is marketable securities, such as the stock of another company, which are recorded at their current market value. It is important to note that accounting statements are records of past performance; they are based on historical costs, not on current market prices or values. Accounting statements translate the business's past performance into dollars and cents, which helps management and investors better understand how the business has performed in the past.

Aligning the Interests of Management and Stockholders

If the linkage between stockholder and management goals is weak, a number of mechanisms can help to better align the behavior of managers with the goals of stockholders. These include (1) board of directors, (2) management compensation, (3) managerial labor market, (4) other managers, (5) large stockholders, (6) the takeover market, and (7) the legal and regulatory environment.

Private Placements

In contrast to public markets, private markets involve direct transactions between two parties. Transactions in private markets are often called private placements. In private markets, a company contacts investors directly and negotiates a deal to sell them all or part of a security issue. Larger firms may be equipped to handle these transactions themselves. Smaller firms are more likely to use the services of an investment bank, which will help locate investors, help negotiate the deal, and handle the legal aspects of the transaction. Major advantages of a private placement are the speed at which funds can be raised and low transaction costs. Downsides are that privately placed securities cannot legally be sold in the public markets because they lack SEC registration and the dollar amounts that can be raised tend to be smaller.

Privately or closely held

In contrast, privately held, or closely held, corporations are typically owned by a small number of investors, and their shares are not traded publicly. When a corporation is first formed, the common stock is often held by a few investors, typically the founder, a small number of key managers, and financial backers. Over time, as the company grows in size and needs larger amounts of capital, management may decide that the company should "go public" in order to gain access to the public markets. Not all privately held corporations go public, however.

Generally Accepted Accounting Principles

In the United States, accounting statements are prepared in accordance with generally accepted accounting principles (GAAP), a set of widely agreed-upon rules and procedures that define how companies are to maintain financial records and prepare financial reports. These principles are important because without them, financial statements would be less standardized. Accounting standards such as GAAP make it easier for analysts and management to make meaningful comparisons of a company's performance against that of other companies. Accounting principles and reporting practices for U.S. firms are promulgated by the Financial Accounting Standards Board (FASB), a not-for-profit body that operates in the public interest. FASB derives its authority from the Securities and Exchange Commission (SEC). GAAP and reporting practices are published in the form of FASB statements, and certified public accountants are required to follow these statements in their auditing and accounting practices.

Limited Liability partnerships

In the early 1980s, because of sharp increases in the number of professional malpractice cases and large damages awards in the courts, professional groups began lobbying state legislators to create a hybrid form of business organization. These organizations, known as limited liability partnerships (LLPs), are now permitted in most states. An LLP combines the limited liability of a corporation with the tax advantage of a partnership—there is no double taxation. In general, income to the partners of an LLP is taxed as personal income, the partners have limited liability for the business, and they are not personally liable for other partners' malpractice or professional misconduct. Other more recent organizational forms that are essentially equivalent to LLPs include limited liability companies (LLCs) and professional corporations (PCs).

Direct Financing

In this section we turn our attention to direct financing, in which funds flow directly through the financial system. In direct transactions, the lender-savers and the borrower-spenders deal directly with one another; borrower-spenders sell securities, such as stocks and bonds, to lender-savers in exchange for money. These securities represent claims on the borrowers' future income or assets. A number of different interchangeable terms are used to refer to securities, including financial securities, financial instruments, and financial claims. The financial markets in which direct transactions take place are wholesale markets with a typical minimum transaction size of $1 million. For most business firms, these markets provide funds at the lowest possible cost. The major buyers and sellers of securities in the direct financial markets are commercial banks; other financial institutions, such as insurance companies and business finance companies; large corporations; the federal government; hedge funds; and some wealthy individuals. It is important to note that financial institutions are major buyers of securities in the direct financial markets. For example, life and casualty insurance companies buy large quantities of corporate bonds and stocks for their investment portfolios. In Exhibit 2.1 the arrow leading from financial institutions to financial markets depicts this flow. Although few individuals participate in direct financial markets, individuals can gain access to many of the financial products produced in these markets through retail channels at investment or commercial banks or independent brokerage firms (the lower route in Exhibit 2.1). For example, individuals can buy or sell stocks and bonds in small dollar amounts at Bank of America's retail brokerage business or the discount brokerage firm Ameritrade. We discuss indirect financing through financial institutions later in this chapter.

Information Asymmetry

Information asymmetry occurs when one party in a business transaction has information that is unavailable to the other parties in the transaction. The existence of information asymmetry in business relationships is commonplace. For example, suppose you decide to sell your 10-year-old car. You know much more about the real condition of the car than does the prospective buyer. The ethical issue is this: How much should you tell the prospective buyer? In other words, to what extent is the party with the information advantage obligated to reduce the amount of information asymmetry? Society imposes both market-based and legal solutions for transactional information asymmetries. Consider the prospective car buyer in the previous example. You can be reasonably sure that the buyer understands that he or she has less information about the car's condition than the seller and, as a result, will pay a lower price for the vehicle. Conversely, sellers who certify or provide a warranty with respect to the condition of the vehicle reduce the concerns that buyers have about information asymmetries and therefore tend to receive higher prices. Legal solutions often require sellers to disclose material facts to buyers or prohibit trading on information that is not widely available. For example, when you sell a car, you are required to disclose to the seller whether it has been in an accident and whether the odometer has been altered. Similarly, in many states home sellers must disclose if they are aware of any major defects in their home. In the investment world, the trading of stocks based on material inside information (e.g., which is not available to the public) has been made illegal in an effort to create a "level playing field" for all investors.

Accounting for Inventory

Inventory, as noted earlier, is a current asset on the balance sheet, but it is usually the least liquid of the current assets. The reason is that it can take a long time for a firm to convert inventory into cash. For a manufacturing firm, the inventory cycle begins with raw materials, continues with goods in process, proceeds with finished goods, and finally concludes with selling the asset for cash or an account receivable. For a firm such as The Boeing Company, for example, the inventory cycle in manufacturing an aircraft can be nearly a year. An important decision for management is the selection of an inventory valuation method. The most common methods are FIFO (first in, first out) and LIFO (last in, first out). During periods of changing price levels, how a firm values its inventory affects both its balance sheet and its income statement. For example, suppose that prices have been rising (inflation). If a company values its inventory using the FIFO method, when the firm makes a sale, it assumes the sale is from the oldest, lowest-cost inventory—first in, first out. Thus, during rising prices, firms using FIFO will have the lowest cost of goods sold, the highest net income, and the highest inventory value. In contrast, a company using the LIFO method assumes the sale is from the newest, highest-cost inventory—last in, first out. During a period of inflation, firms using LIFO will have the highest cost of goods sold, the lowest net income, and the lowest inventory value. Because inventory valuation methods can have a significant impact on both the income statement and the balance sheet, when financial analysts compare different companies, they make adjustments to the financial statements for differences in inventory valuation methods. Although firms can switch from one inventory valuation method to another, this type of change is an extraordinary event and cannot be done frequently. Diaz Manufacturing reports inventory values in the United States using the LIFO method. The remaining inventories, which are located outside the United States and Canada, are calculated using the FIFO method. Diaz's total inventory is $423.8 million.

Investment banks

Investment banks specialize in helping companies sell new debt or equity, although they can also provide other services, such as the broker and dealer services discussed later in this chapter and traditional banking services

Investment Funds

Investment funds, such as mutual funds, sell shares to investors and use the funds to purchase securities. As a result, they are an important source of business funding. For example, mutual funds may focus on purchasing (1) equity or debt securities; (2) securities of small or medium-sized corporations; (3) securities of companies in a particular industry, such as energy, computer, or information technology; or (4) foreign investments

Market Value Balance Sheet

Let's look at an example of how a market-value balance sheet can differ from a book-value balance sheet. Marvel Airline is a small regional carrier that has been serving the Northeast for five years. The airline has a fleet of short-haul jet aircraft, most of which were purchased over the past two years. The fleet has a book value of $600 million. Recently, the airline industry has suffered substantial losses in revenue due to price competition, and most carriers are projecting operating losses for the foreseeable future. As a result, the market value of Marvel's aircraft fleet is only $400 million. The book value of Marvel's long-term debt is $300 million, which is near its current market value. The firm has 100 million shares outstanding. Using these data, we can construct two balance sheets, one based on historical book values and the other based on market values: Based on the book-value balance sheet, the firm's financial condition looks fine; the book value of Marvel's aircraft at $600 million is near what the firm paid, and the stockholders' equity account is $300 million. But when we look at the market-value balance sheet, a different story emerges. We immediately see that the value of the aircraft has declined by $200 million and the stockholders' equity has declined by $200 million! Why the decline in stockholders' equity? Recall that in Chapter 1 we argued that the value of any asset—stocks, bonds, or a firm—is determined by the future cash flows the asset will generate. At the time the aircraft were purchased, it was expected that they would generate a certain amount of cash flows over time. Now that hard times plague the industry, the cash flow expectations have been lowered, and hence the decline in the value of stockholders' equity.

Long Term Liabilities

Long-term liabilities include debt instruments due and payable beyond one year as well as other long-term obligations of the firm. They include bonds, bank term loans, mortgages, and other types of liabilities, such as pension obligations and deferred compensation. Typically, firms finance long-term assets with long-term liabilities. Diaz Manufacturing has a single long-term liability of $574.0 million, which is a long-term debt.

Long Term Assets

Long-term productive assets are the assets that the firm uses to generate most of its income. Long-term assets may be tangible or intangible. Tangible assets are balance sheet items such as land, mineral resources, buildings, equipment, machinery, and vehicles that are used over an extended period of time. In addition, tangible assets can include other businesses that a firm wholly or partially owns, such as foreign subsidiaries. Intangible assets are items such as patents, copyrights, licensing agreements, technology, and other intellectual capital the firm owns. Goodwill is an intangible asset that arises only when a firm purchases another firm. Conceptually, goodwill is a measure of how much the price paid for the acquired firm exceeds the sum of the values of its individual assets. There are a variety of reasons why the purchase price of an asset might exceed its value to the seller. Goodwill may arise from improvements in efficiency, the reputation or brands associated with products or trademarks, or even a valuable client base for a particular service. For example, if Diaz Manufacturing paid $2.0 million for a company that had individual assets with a total fair market value of $1.9 million, the goodwill premium paid would be $100,000 . Diaz Manufacturing's long-term assets comprise net plant and equipment of $399.4 million and intangible and other assets of $450.0 million, as shown in Exhibit 3.1. The term net plant and equipment indicates that accumulated depreciation has been subtracted to arrive at the net value. That is, net plant and equipment equals total plant and equipment less accumulated depreciation; accumulated depreciation is the total amount of depreciation expense taken on plant and equipment up to the balance sheet date. For Diaz Manufacturing, the above method yields the following result:

Net Working Captial

Management must also decide how to manage the firm's current assets, such as cash, inventory, and accounts receivable, and its current liabilities, such as trade credit and accounts payable. The dollar difference between a firm's total current assets and its total current liabilities is called its net working capital, as shown in Exhibit 1.2.

Overarching Strategies

The accounting fraud at WorldCom followed similar scandals at Enron, Global Crossing, Tyco, and elsewhere. These scandals—and the resulting losses to stockholders—led to a set of far-reaching regulatory reforms passed by Congress in 2002.6 The most significant reform measure to date is the Sarbanes-Oxley Act of 2002, which focuses on (1) reducing agency costs in corporations, (2) restoring ethical conduct within the business sector, and (3) improving the integrity of accounting reporting system within firms. Overall, the new regulations require all public corporations to implement five overarching strategies. (Private corporations and partnerships are not required to implement these measures.) 1. Ensure greater board independence. Firms must restructure their boards so that the majority of the members are outside directors. Furthermore, it is recommended that the positions of chair and CEO be separated. Finally, Sarbanes-Oxley makes it clear that board members have a fiduciary responsibility to represent and act in the interest of stockholders, and board members who fail to meet their fiduciary duty can be fined and receive jail sentences. 2. Establish internal accounting controls. Firms must establish internal accounting control systems to protect the integrity of the accounting systems and safeguard the firms' assets. The internal controls are intended to improve the reliability of accounting data and the quality of financial reports and to reduce the likelihood that individuals within the firm engage in accounting fraud. 3. Establish compliance programs. Firms must establish corporate compliance programs that ensure that they comply with important federal and state regulations. For example, a compliance program would document whether a firm's truck drivers complied with all federal and state truck and driver safety regulations, such as the number of hours one can drive during the day and the gross highway weight of the truck. 4. Establish an ethics program. Firms must establish ethics programs that monitor the ethical conduct of employees and executives through a compliance hotline, which must include a whistleblower protection provision. The intent is to create an ethical work environment so that employees will know what is expected of them and their relationships with customers, suppliers, and other stakeholders. 5. Expand the audit committee's oversight powers. The external auditor, the internal auditor, and the compliance/ethics officer owe their ultimate legal responsibilities to the audit committee, not to the firm. In addition, the audit committee has the unconditional power to probe and question any person in the firm, including the CEO, regarding any matter that might materially impact the firm or its financial statements. Exhibit 1.5 summarizes some of the recent regulatory changes that are designed to reduce agency costs.

The Annual Report

The annual report is the most important report that firms issue to their stockholders and make available to the general public. Historically, annual reports were dull, black-and-white publications that presented audited financial statements for firms. Today some annual reports, especially those of large public companies, are slick, picture-laden, glossy "magazines" in full color with orchestrated media messages. Annual reports typically are divided into three distinct sections. First are the financial tables, which contain financial information about the firm and its operations for the year, and an accompanying summary explaining the firm's performance over the past year. For example, the summary might explain that sales and profits were down because of declining consumer demand in the wake of the 2008 financial crisis. Often, there is a letter from the chairman or CEO that provides some insights into the reasons for the firm's performance, a discussion of new developments, and a high-level view of the firm's strategy and future direction. It is important to note that the financial tables are historical records reflecting past performance of the firm and do not necessarily indicate what the firm will do in the future. The second part of the report is often a corporate public relations piece discussing the firm's product lines, its services to its customers, and its contributions to the communities in which it operates. The third part of the annual report presents the audited financial statements: the balance sheet, the income statement, the statement of retained earnings, and the statement of cash flows. Overall, the annual report provides a good overview of the firm's operating and financial performance and states why, in management's judgment, things turned out the way they did.

Balance Sheet

The balance sheet reports the firm's financial position at a particular point in time. Exhibit 3.1 shows the balance sheets for Diaz Manufacturing on December 31, 2010 and December 31, 2011. The left-hand side of the balance sheet identifies the firm's assets, which are listed at book value. These assets are owned by the firm and are used to generate income. The right-hand side of the balance sheet includes liabilities and stockholders' equity, which tell us how the firm has financed its assets. Liabilities are obligations of the firm that represent claims against its assets. These claims arise from debts and other obligations to pay creditors, employees, or the government. In contrast, stockholders' equity represents the residual claim of the owners on the remaining assets of the firm after all liabilities have been paid.2 The basic balance sheet identity can thus be stated as follows:3 (3.1) Since stockholders' equity is the residual claim, stockholders would receive any remaining value if the firm decided to sell off all of its assets and use the money to pay its creditors. That is why the balance sheet always balances. Simply put, if you total what the firm owns and what it owes, then the difference between the two is the total stockholders' equity: Notice that total stockholders' equity can be positive, negative, or equal to zero. It is important to note that balance sheet items are listed in a specific order. Assets are listed in order of their liquidity, with the most liquid assets, cash and marketable securities, at the top. The liquidity of an asset is defined by how quickly it can be converted into cash without loss of value. Thus, an asset's liquidity has two dimensions: (1) the speed and ease with which the asset can be sold and (2) whether the asset can be sold without loss of value. Of course, any asset can be sold easily and quickly if the price is low enough. Liabilities on the balance sheet are listed based on their maturity, with the liabilities having the shortest maturities listed at the top. Maturity refers to the length of time remaining before the obligation must be paid. Next, we examine some important balance sheet accounts of Diaz Manufacturing as of December 31, 2011 (see Exhibit 3.1). As a matter of convention, accountants divide assets and liabilities into short-term (or current) and long-term parts. We will start by looking at current assets and liabilities.

Stockholders Equity

The book value of the firm's equity is one of the least informative items on the balance sheet. The book value of equity, as suggested earlier, is simply a historical record. As a result, it says very little about the current market value of the stockholders' stake in the firm. In contrast, on a balance sheet where both assets and liabilities are marked to market, the firm's equity is more informative to management and investors. The difference between the market values of the assets and liabilities provides a better estimate of the market value of stockholders' equity than the difference in the book values. Intuitively, this makes sense because if you know the "true" market value of the firm's assets and liabilities, the difference must equal the market value of the stockholders' equity. You should be aware, however, that the difference between the sum of the market values of the individual assets and total liabilities will not give us an exact estimate of the market value of stockholders' equity. The reason is that the true total value of a firm's assets depends on how these assets are utilized. By utilizing the assets efficiently, management can make the total value greater than the simple sum of parts. We will discuss this concept in more detail in Chapter 18. Finally, if you know the market value of the stockholders' equity and the number of shares of stock outstanding, it is easy to compute the stock price. Specifically, the price of a share of stock is the market value of the firm's stockholders' equity divided by the number of shares outstanding.

Capital Budgeting

The decision-making process through which the firm purchases long-term productive assets is called capital budgeting, and it is one of the most important decision processes in a firm.

Average versus marginal tax rates

The difference between the average tax rate and the marginal tax rate is an important consideration in financial decision making. The average tax rate is simply the total taxes paid divided by taxable income. In contrast, the marginal tax rate is the tax rate that is paid on the last dollar of income earned. Exhibit 3.6 shows both the marginal tax rates and average tax rates for corporations. A simple example will clarify the difference between the average and marginal tax rates. Suppose a corporation has a taxable income of $150,000. Using the data in Exhibit 3.6, we can determine the firm's federal income tax bill, its marginal tax rate, and its average tax rate. The firm's total tax bill is computed as follows: The firm's average tax rate is equal to the total taxes divided by the firm's total taxable income; thus, the average tax rate is , or 27.8 percent. The firm's marginal tax rate is the rate paid on the last dollar earned, which is 39 percent. When you are making investment decisions for a firm, the relevant tax rate to use is usually the marginal tax rate. The reason is that new investments (projects) are expected to generate new cash flows, which will be taxed at the firm's marginal tax rate. To simplify calculations throughout the book, we will generally specify a single tax rate for a corporation, such as 40 percent. The rate may include some payment for state and local taxes, which will make the total tax rate the firm pays greater than the federal rate.

The Financial System

The financial system consists of financial markets and financial institutions. Financial market is a general term that includes a number of different types of markets for the creation and exchange of financial assets, such as stocks and bonds. Financial institutions are firms such as commercial banks, credit unions, insurance companies, pension funds, and finance companies that provide financial services to the economy. The distinguishing feature of financial institutions is that they invest their funds in financial assets, such as business loans, stocks, and bonds, rather than real assets, such as plant and equipment. The critical role of the financial system in the economy is to gather money from people and businesses with surplus funds to invest and channel that money to those who need it. Businesses need money to invest in new productive assets to expand their operations and increase the firm's cash flow, which should increase the value of the firm. Consumers, too, need money, which they use to purchase things such as homes, cars, and boats—or to pay college tuition bills. Some of the players in the financial system are household names such as the New York Stock Exchange, Bank of America, Merrill Lynch, and State Farm Insurance. Others are lesser-known but important firms, such the multinational giant GE Capital. A well-developed financial system is critical for the operation of a complex industrial economy such as that of the United States. Highly industrialized countries cannot function without a competitive and sound financial system that efficiently gathers money and channels it into the best investment opportunities. Let's look at a simple example to illustrate how the financial system channels money to businesses.

Net Income

The firm's net income reflects its accomplishments (revenues) relative to its efforts (expenses) during a time period. If revenues exceed expenses, the firm generates net income for the period. If expenses exceed revenues, the firm has a net loss. Net income is often referred to as profits, as income, or simply as the "bottom line," since it is the last item on the income statement. Net income is often reported on a per-share basis and is then called earnings per share (EPS), where EPS equals net income divided by the number of common shares outstanding. A firm's earnings per share tell a stockholder how much the firm has earned (or lost) for each share of stock outstanding. Income statements for Diaz Manufacturing for 2010 and 2011 are shown in Exhibit 3.2. You can see that in 2011 total revenues from all sources (net sales) were $1,563.7 million. Total expenses for producing and selling those goods were $1,445.2 million—the total of the amounts for cost of goods sold, selling and administrative expenses, depreciation, interest expense, and taxes.5\ Using Equation 3.3, we can use these numbers to calculate Diaz Manufacturing's net income for the year: Since Diaz Manufacturing had 54,566,054 common shares outstanding at year's end, its EPS was $2.17 per share .

The Going Concern Assumption

The going concern assumption is the assumption that a business will remain in operation for the foreseeable future. This assumption underlies much of what is done in accounting. For example, suppose that Kmart has $4.6 billion of inventory on its balance sheet, representing what the firm actually paid for the inventory in arm's-length transactions. If we assume that Kmart is a going concern, the balance sheet figure is a reasonable number because in the normal course of business we expect Kmart to be able to sell the goods for its cost plus some reasonable markup. However, suppose Kmart declares bankruptcy and is forced by its creditors to liquidate its assets. If this happens, Kmart is no longer a going concern. What will the inventory be worth then? We cannot be certain, but 50 cents on the dollar might be a high figure. The going concern assumption allows the accountant to record assets at cost rather than their value in a liquidation sale, which is usually much less. You can see that the fundamental accounting principles just discussed leave considerable professional discretion to accountants in the preparation of financial statements. As a result, financial statements can and do differ because of honest differences in professional judgments. Of course, there are limits on honest professional differences, and at some point, an accountant's choices can cross a line and result in "cooking the books."

Income Statement

The income statement summarizes the revenues, expenses, and the profitability (or losses) of the firm over some period of time, usually a month, a quarter, or a year. The basic equation for the income statement can be expressed as follows: (3.3) Let's look more closely at each element in this equation.

Capital Management

The management of current assets, such as money owed by customers who purchase on credit, inventory, and current liabilities, such as money owed to suppliers, is called working capital management

Storm Form Efficency

The market for a security is perfectly informationally efficient if the security's price always reflects all information. The idea that all information about a security is reflected in its price is known as the strong-form of the efficient market hypothesis. Few people really believe that market prices of public securities reflect all available information, however. It is widely accepted that insiders have information that is not reflected in the security prices. Thus, the concept of strong-form market efficiency represents the ideal case rather than the real world. If a security market were strong-form efficient, then it would not be possible to earn abnormally high returns (returns greater than those justified by the risks) by trading on private information—information unavailable to other investors—because there would be no such information. In addition, since all information would already be reflected in security prices, the price of a share of a particular security would change only when new information about its prospects became available.

Liabilities

The market value of liabilities can also differ from their book value, though typically by smaller amounts than is the case with assets. For liabilities, the balance sheet shows the amount of money that the company has promised to pay. This figure is generally close to the actual market value for short-term liabilities because of their relatively short maturities. For long-term debt, however, book value and market value can differ substantially. The market value of debt with fixed interest payments is affected by the level of interest rates in the economy. More specifically, after long-term debt is issued, if the market rate of interest increases, the market value of the debt will decline. Conversely, if interest rates decline, the value of the debt will increase. For example, assume that a firm has $1 million of 20-year bonds outstanding. If the market rate of interest increases from 5 to 8 percent, the price of the bonds will decline to around $700,000.4 Thus, changes in interest rates can have an important effect on the market values of long-term liabilities, such as corporate bonds. Even if interest rates do not change, the market value of long-term liabilities can change if the performance of the firm declines and the probability of default increases.

Capital Structure

The mix of debt and equity on the balance sheet is known as a firm's capital structure. The term capital structure is used because long-term funds are considered capital, and these funds are raised in capital markets—financial markets where equity and debt instruments with maturities greater than one year are traded.

Market Operational Efficency

The overall efficiency of a market depends on its operational efficiency and its informational efficiency. Market operational efficiency focuses on bringing buyers and sellers together at the lowest possible cost. The costs of bringing buyers and sellers together are called transaction costs and include such things as broker commissions and other fees and expenses. The lower these costs, the more operationally efficient markets are. Why is operational efficiency important? If transaction costs are high, market prices will be more volatile, fewer financial transactions will take place, and prices will not reflect the knowledge and expectations of investors as accurately.

Nominal rate of interest

The real rate of interest is not observable because all industrial economies operate with some degree of inflation. The rate that we actually observe in the marketplace at a given time is unadjusted for inflation and is called the nominal rate of interest. The factors that determine the real rate of interest, however, are the underlying determinants of all interest rates we observe in the marketplace. For this reason, an understanding of the real rate is important.

Agency Conflicts (Agency Relationships)

The relationship we have just described between the pizza parlor owner and the student manager is an example of an agency relationship. An agency relationship arises whenever one party, called the principal, hires another party, called the agent, to perform some service on behalf of the principal. The relationship between stockholders and management is an agency relationship. Legally, managers (who are the agents) have a fiduciary duty to the stockholders (the principals), which means managers are obligated to put the interests of the stockholders above their own. However, in these and all other agency relationships, the potential exists for a conflict of interest between the principal and the agent. These conflicts are called agency conflicts.

Retained Earnings

The retained earnings account represents earnings that have been retained and reinvested in the business over time rather than being paid out as cash dividends. The change in retained earnings from one period to the next can be computed as the difference between net income and dividends paid. Diaz Manufacturing's retained earnings account is only $67.8 million. Reading the annual report, we learn that in the recent past the company "wrote down" the value of a substantial amount of assets. This transaction, which will be discussed later in the chapter, also reduced the size of the retained earnings account by reducing net income. Note that retained earnings are not the same as cash. In fact, as we discuss in Section 3.7 of this chapter, a company can have a very large retained earnings account and no cash. Conversely, it can have a lot of cash and a very small retained earnings account. Because retained earnings appear on the liability side of the balance sheet, they do not represent an asset, as do cash and marketable securities.

Statement of Cash flows

The statement of cash flows shows the company's cash inflows (receipts) and cash outflows (payments and investments) for a period of time. We derive these cash flows by looking at the firm's net income during the period and at changes in balance sheet accounts from the beginning of the period (end of the previous period) to the end of the period. In analyzing the statement of cash flows, it is important to understand that changes in the balance sheet accounts reflect cash flows. More specifically, increases in assets or decreases in liabilities and equity are uses of cash, while decreases in assets or increases in liabilities and equity are sources of cash. These changes in balance sheet items can be summarized by the following: • Working capital. An increase in current assets (such as accounts receivable and inventory) is a use of cash. For example, if a firm increases its inventory, it must use cash to purchase the additional inventory. Conversely, the sale of inventory increases a firm's cash position. An increase in current liabilities (such as accounts or notes payable) is a source of cash. For example, if during the year a firm increases its accounts payable, it has effectively "borrowed" money from suppliers and increased its cash position. • Fixed assets. An increase in long-term fixed assets is a use of cash. If a company purchases fixed assets during the year, it decreases cash because it must use cash to pay for the purchase. If the firm sells a fixed asset during the year, the firm's cash position will increase. • Long-term liabilities and equity. An increase in long-term debt (bonds and private placement debt) or equity (common and preferred stock) is a source of cash. The retirement of debt or the purchase of treasury stock requires the firm to pay out cash, reducing cash balances. • Dividends. Any cash dividend payment decreases a firm's cash balance.

Treasury Stock

The treasury stock account represents stock that the firm has purchased back from investors. Publicly traded companies can simply buy shares of stock from stockholders on the market at the prevailing price. Typically, repurchased stock is held as "treasury stock," and the firm can reissue it in the future if it desires. Diaz Manufacturing has spent a total of $23.3 million to repurchase the 571,320 shares of common stock it currently holds as treasury stock. The company has had a policy of repurchasing common stock, which has been subsequently reissued to senior executives under the firm's stock-option plan. You may wonder why a firm's management would repurchase its own stock. This is a classic finance question, and it has no simple answer. The conventional wisdom is that when a company has excess cash and management believes its stock price is undervalued, it makes sense to purchase stock with the cash.

Weak Form Efficiency

The weakest form of the efficient market hypothesis is known, aptly enough, as the weak-form. This hypothesis holds that all information contained in past prices of a security is reflected in current prices but that there is both public and private information that is not. In a weak-form efficient market, it would not be possible to earn abnormally high returns by looking for patterns in security prices, but it would be possible to do so by trading on public or private information. An important conclusion from efficient market theory is that at any point in time, all securities of the same risk class should be priced to offer the same expected return. The more efficient the market, the more likely this is to happen. Since both the bond and stock markets are relatively efficient, this means that securities of similar risk will offer the same expected return. This conclusion is important because it provides the basis for identifying the proper discount rate to use in applying the bond and stock valuation models developed in Chapters 8 and 9.

Maximize current value of the firms stock

Thus, an appropriate goal for management is to maximize the current value of the firm's stock. Maximizing the value of the firm's stock is an unambiguous objective that is easy to measure. We simply look at the market value of the stock in the newspaper on a given day to determine the value of the stockholders' shares and whether it went up or down. Publicly traded securities are ideally suited for this task because public markets are wholesale markets with large numbers of buyers and sellers where securities trade near their true value

ownership and Control

To illustrate, let's continue with our pizza parlor example. As the owner of a pizza parlor, you have decided your goal is to maximize the value of the business, and thereby your ownership interest. There is no conflict of interest in your dual roles as owner and manager because your personal and economic self-interest is tied to the success of the pizza parlor. The restaurant has succeeded because you have worked hard and have focused on customer satisfaction. Now suppose you decide to hire a college student to manage the restaurant. Will the new manager always act in your interest? Or could the new manager be tempted to give free pizza to friends now and then or, after an exhausting day, leave early rather than spend time cleaning and preparing for the next day? From this example, you can see that once ownership and management are separated, managers may be tempted to pursue goals that are in their own self-interest rather than the interests of the owners.

Productive Assets

To produce its products or services, a new firm needs to acquire a variety of assets. Most will be long-term assets, which are also known as productive assets

Initial Public Offering (IPO)

To start the new company, management's first task is to sell equity and debt to finance the expansion of the firm. 3M and the senior management team will provide 40 percent of the equity, and the balance will come from an initial public offering (IPO) of common stock. An IPO is a corporation's first offering of its stock to the public. For example, management hires Morgan Stanley as its investment bank to underwrite the new securities. After the deal is underwritten, the new venture receives the proceeds from the stock sale, less Morgan Stanley's underwriting fees (see arrow E in the exhibit).4

Life and Casualty Insurance Companies

Two types of insurance companies are important in the financial markets: (1) life insurance companies and (2) casualty insurance companies, which sell protection against loss of property from fire, theft, accidents, and other predictable causes. The cash flows for both types of companies are fairly predictable. As a result, they are able to provide funding to corporations through the purchase of stocks and bonds in the direct credit markets as well as funding for both public and private corporations through private placement financing. Businesses of all sizes purchase life insurance programs as part of their employee benefit packages and purchase casualty insurance policies to protect physical assets such as automobiles, truck fleets, equipment, and entire plants.

Brokers

Two types of market specialists facilitate transactions in secondary markets. Brokers are market specialists who bring buyers and sellers together when a sale takes place. They execute the transaction for their client and are compensated for their services with a commission fee. They bear no risk of ownership of the securities during the transactions; their only service is that of "matchmaker."

The Realization Principle

Under the realization principle, revenue is recognized only when the sale is virtually completed and the exchange value for the goods or services can be reliably determined. As a practical matter, this means that most revenues are recognized at the time of sale whether or not cash is actually received. At this time, if a firm sells to its customers on credit, an account receivable is recorded. The firm receives the cash only when the customer actually makes the payment. Although the realization principle concept seems straightforward, there can be considerable ambiguity in its interpretation. For example, should revenues be recognized when goods are ordered, when they are shipped, or when payment is received from the customer?

Underwriting

Underwriting is the process by which the investment banker helps the company sell its new security issue. In the most common type of underwriting arrangement, called firm-commitment underwriting, the investment banker buys the new securities from the issuing company and resells them to investors. Because the investment banker buys the entire security issue from the company at a fixed price, the issuing company is guaranteed that price. On the other hand, the investment banker takes the risk that the actual price at which the shares are sold is less than the price that is paid to the company. Since issuing companies typically need a certain amount of money to pay for a particular project or to fund operations, and getting anything less than this amount can pose a serious problem, financial managers almost always prefer to have their new security issues underwritten on a firm-commitment basis.2 Once the investment bankers buy the securities from the issuer, they immediately offer to resell individual securities to institutional investors and the public at a specified offering price. The underwriters hope to be able to sell the offering at the market-clearing price, which is the price that will allow the entire security issue to be sold during the first day of sale. Underwriting involves considerable risk because it is difficult to estimate the price that will clear the market. If the investment bank has to sell the securities at a price below the price that it paid to the issuing company, the investment bank suffers a financial loss. The investment banker's compensation is called the underwriting spread. It is the difference between the offering price and the price the investment banker pays for the security issue. The underwriting spread is one of the costs to the firm of selling new securities.

Financial Market

We have seen that direct flows of funds occur in financial markets. However, as already mentioned, financial market is a very general term. A complex industrial economy such as ours includes many different types of financial markets, and not all of them are involved in direct financing. Next, we examine some of the more important ways to classify financial markets. Note that these classifications overlap to a large extent. Thus, for example, the New York Stock Exchange fits into several different categories.

How funds flow through the financial system

We have seen that the financial system plays a critical role in the economy. The system moves money from lender-savers (whose income exceeds their spending) to borrower-spenders (whose spending exceeds their income), as shown schematically in Exhibit 2.1. The most important group of lender-savers in the economy are households, but some businesses and many state and local governments at times have excess funds to lend to those who need money. As a group, businesses are the borrower-spenders who borrow the most in the economy, followed by the federal government.The arrows in Exhibit 2.1 show that there are two basic mechanisms by which funds flow through the financial system: (1) funds can flow directly through financial markets (the route at the top of the diagram) and (2) funds can flow indirectly through financial institutions (the route at the bottom of the diagram). In the following three sections, we look more closely at the direct flow of funds and at the financial markets. After that, we discuss financial institutions and the indirect flow of funds.

Equity

We have summarized the types of assets and liabilities that appear on the balance sheet. Now we look at the equity accounts. Diaz Manufacturing's total stockholders' equity at the end of 2011 is $937.4 million and is made up of four accounts—common stock, additional paid-in capital, retained earnings, and treasury stock—which we discuss next. We conclude with a discussion of preferred stock. Although a line item for preferred stock appears on Diaz Manufacturing's balance sheets, the company has no shares of preferred stock outstanding. The Common Stock Accounts The most important equity accounts are those related to common stock, which represent the true ownership of the firm. Certain basic rights of ownership typically come with common stock; those rights are as follows: 1. The right to vote on corporate matters such as the election of the board of directors or important actions such as the purchase of another company. 2. The preemptive right, which allows stockholders to purchase any additional shares of stock issued by the corporation in proportion to the number of shares they currently own. This allows common stockholders to retain the same percentage of ownership in the firm, if they choose to do so. 3. The right to receive cash dividends if they are paid. 4. If the firm is liquidated, the right to all remaining corporate assets after all creditors and preferred stockholders have been paid. A common source of confusion is the number of different common stock accounts on the balance sheet, each of which identifies a source of the firm's equity. The common stock account identifies the initial funding from investors that was used to start the business and is priced at a par value. The par value is an arbitrary number set by management, usually a nominal amount such as $1. Clearly, par value has little to do with the market value of the stock when it is sold to investors. The additional paid-in capital is the amount of capital received for the common stock in excess of par value. Thus, if the new business is started with $40,000 in cash and the firm decides to issue 1,000 shares of common stock with a par value of $1, the owners' equity account looks as follows: Common stock (1,000 shares @ $1 par value) $ 1,000 Additional paid-in capital 39,000 Total paid-in capital $40,000 Note the money put up by the initial investors: $1,000 in total par value (1,000 shares of common stock with a par value of $1) and $39,000 additional paid-in capital, for a total of $40,000. As you can see in Exhibit 3.1, Diaz manufacturing has 54,566,054 shares of common stock with a par value of 91.63 cents, for a total value of $50.0 million . The additional paid-in capital is $842.9 million. Thus, Diaz's total paid-in capital is $892.9 million .

Maximize the current value of the firms equity

What about firms whose equity is not publicly traded, such as private corporations and partnerships? The total value of the stockholder or partner interests in such a business is equal to the value of the owner's equity. Thus, our goal can be restated for these firms as this: maximize the current value of owner's equity. The only other restriction is that the entities must be for-profit businesses. It is important to recognize that maximizing the value of stock, or owner's equity, is not necessarily inconsistent with maximizing the value of claims to the firm's other stakeholders. For example, suppose the managers of a firm decide to delay paying suppliers in an effort to increase the cash flows to the firm's owners. An action such as this is likely to be met by resistance from suppliers who might increase the prices they charge the firm in order to offset the cost of this policy to them. In the extreme, the suppliers might stop selling their products to the firm and both the firm's owners and the suppliers can end up worse off. Consequently, in maximizing the value of the owner's equity, managers make decisions that account for the interests all stakeholders. Quite often, what is best for the firm's owners also benefits other stakeholders

Accumulated Depreciation

When a firm acquires a tangible asset that deteriorates with use and wears out, accountants try to allocate the asset's cost over its useful life. The matching principle requires that the cost be expensed during the period in which the firm benefited from use of the asset. Thus, depreciation allocates the cost of a limited-life asset to the periods in which the firm is assumed to benefit from the asset. Tangible assets with an unlimited life, such as land, are not depreciated. Depreciation affects the balance sheet through the accumulated depreciation account; we discuss its effect on the income statement in Section 3.4. A company can elect whether to depreciate its assets using straight-line depreciation or one of the approved accelerated depreciation methods. Accelerated depreciation methods allow for more depreciation expense in the early years of an asset's life than straight-line depreciation. Diaz Manufacturing uses the straight-line method of depreciation. Had Diaz elected to use accelerated depreciation, the value of its depreciable assets would have been written off to the income statement more quickly as a higher depreciation expense, which results in a lower net plant and equipment account on its balance sheet and a lower net income for the period.

Stakeholder

is someone other than an owner who has a claim on the cash flows of the firm: managers, who want to be paid salaries and performance bonuses; other employees, who want to be paid wages; suppliers, who want to be paid for goods or services; the government, which wants the firm to pay taxes; and creditors, who want to be paid interest and principal.